In some exchanges so called derivative contracts are traded. Derivative contracts are contracts that are derived from underlying contracts. The underlying contracts can for example be stock, bond, or commodity contracts. The underlying contract can also in some cases in itself be a derivative contract. The price for the derivative contract is dependent on the price of the underlying contract(s). Examples of derivative contracts include option contracts and future contracts of different types.
In the case of a future contract there is a direct correlation between the future contract price and the price for the underlying contract. Thus if, for example, the price for a particular stock increases by one dollar, the price for the future contract having that particular stock as an underlying contract will also increase by one dollar.
However, this direct correlation is not valid for most types of derivative contracts. For example the price of an option may depend on the underlying price as a factor*(the change in the underlying price), where the factor is between nil and one for a call option and nil and minus one for a put option. This means that if the price of the underlying contract increases by one the price of a call option will always increase by at the most one. This factor is usually termed delta or delta value.
In the market there are several types of trader parties. One particular type of trader party is the market maker which is a market participant obliged to provide prices to the market in one or several instruments traded in the market. The market maker gains from the trading by having a small spread between its buy and sell prices. The market maker does not want to hold the risk in any instrument it trades. However, if the market maker provides prices to the market in a derivative contract and somebody else trades against those prices, the market maker is left with what is termed an open position. This means that the market maker will lose or make money if the price of the underlying contract changes. Since the market makers role is to provide liquidity to the market and not take the risk of the instrument, the risk is undesired from the market maker's view.
The biggest short-term risk of an open derivative position is the risk that the underlying price will change, thereby causing the derivative contract price to change. In order to decrease this risk the market maker can buy underlying contracts to offset this open position. The number of contracts that the market maker has to buy of the underlying instrument depends on the current delta/delta value.
Thus, if for example the delta value is 0.5 a market maker has to trade 0.5 underlying contracts for each derivative contract to hedge the open position resulting from the deal in the derivative contract. Of course, other market participants may also be interested in trading without entering an open position. When a derivative position is hedged in this way the trade is said to be delta neutral.
The price of a derivative contract may not only depend on the price of the underlying contract. For example the price of an option is also dependent on the volatility of the underlying contract. Thus, if an option contract is delta hedged the position is less exposed to price changes of the underlying contract and thus relatively more dependant on changes in the volatility of the underlying contract. This is a common way of trading option contracts. The open delta position is hedged according to the delta value. This is also called to cover the option. This can of course be done for put and call options as well as for more complex option contracts or combinations of option contracts.
The transactions required in the delta hedging of open derivative positions are done today over the phone or by phone and electronic system together. When the trade is carried out in two or more places there is always a so-called execution risk. This means that a market participant assumes that he/she can carry out both parts of the transaction and price it accordingly. When the trade is done the participants may not be able to hedge the open position at the price set when the first order was executed because the prices and/or volumes in one of the marketplaces have changed. This is usually called execution risk or liquidity risk.
Furthermore, in many automated exchange systems it is usually possible to set up combinations of securities, but these are today limited to combinations of natural numbers. For example, combination AB, sell 1 of A and buy 1 of B, or combination CD sell 2 of C and sell 1 of D. These ratios are fixed during the day and are usually used for strategies such as straddles, strangles, time spreads etc. These existing combinations do not fulfill the needs of somebody that wants to delta hedge a position because the delta of an option contract changes with the changes of the price of the underlying contract.
Combination orders usually generate derived orders in the market of the separate instruments. For example, a person may wish to sell a particular future and buy a call option derived from that particular future. When a price exists for one of the contracts, i.e., in either the future or the option, a derived order will be created in the other contract of the combination contract by the automated exchange system. This process is very demanding in terms of processing power in the matching unit utilized by the automated exchange, which is unfortunate, because the processing power of the matching unit often is a bottleneck in a conventional automated trading system.